Credit Instruments and Commercial Obligations

Posted on Sep 6, 2024 in Law & Jurisprudence

Seven C’s

Capacity
Cash Flow
Capital
Collateral
Character
Conditions
Commitment

Types of Credit (Commercial Obligation)

Bank Loans

(Long Term, Short-Term)
Trade Credit
(Supplier Credit)
Trading Obligations
(Foreign Exchange and Derivatives)
Rated (Public) Obligations
(From Short-Term to Long-Term)
Subordinated Forms of Equity
(Preferred Stock)

Types of Credit (Length of Indebtedness)

1. Short-Term Debt (On Demand, Rolled-Over)

Trade
Bank
Corporate

2. Long-Term Debt (Amortizing, Lump-Sum)

Bank
Corporate
Refinancing

Determining what is “reasonable” leads to the “art” of credit analysis.
Judgments must be made about the forecasts of performance relative to history,
management capability,
competitors’ performance and
competitive pressure, and
the macroeconomic environment.
Judgments must also be made about the strength or weakness of the obligor’s current and future financial position.

Working Capital Requirement

A. Cash Credit

A borrower is allowed to withdraw funds from the bank up to the sanctioned credit limit.

B. Working Capital Demand Loan

A borrower may sometimes require ad hoc or temporary accommodation in excess of the sanctioned credit limit to meet unforeseen contingencies.
(The borrower is required to pay a higher rate of interest above the normal rate on such additional credit.)

C. Overdraft

It is similar to a cash credit arrangement. Under the overdraft facility, the borrower is allowed to withdraw funds in excess of the balance in his current account up to a certain specified limit during a stipulated period.
(Interest is charged on daily balances, on the amount actually withdrawn, subject to some minimum charges.)

D. Commercial Paper

Commercial paper (CP) is an important money market instrument to raise short-term funds. CP is a form of unsecured promissory note issued by firms to raise short-term funds.

E. Revolver

A revolver (RV), or credit line or revolving line, is a credit agreement in which the borrower has the right to choose when to obtain funds and when to repay funds and how much to borrow, within limits set by the contract.

Capital Expenditure

1. Term Loan

A loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate.
(Term loans can be quite complicated, involving amortization of principal, differing levels of seniority, posting of collateral, detailed covenant restrictions, prepayment penalties and interest and fees that may vary with the borrower’s risk rating or financial performance.)

2. Loan Syndication/Consortium Advance/Multiple Banking Arrangement

Loan syndication is the process of involving several different lenders in providing various portions of a loan.

3. Bond/Debenture

A corporate bond or a debenture is a credit instrument in which the issuer obtains cash from the initial investors at origination and, in return, agrees to make payments of interest and, at maturity, of principal to holders of the securities.

Negotiable Instruments

1. Promissory Note

A promissory note, also referred to as a note payable in accounting, is a contract where one party (the maker or issuer) makes an unconditional promise in writing to pay a sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee, under specific terms.

2. Bill of Exchange

A bill of exchange or “Draft” is a written order by the drawer to the drawee to pay money to the payee.
(Bill of exchange is the most popular instrument of payment in financing internal and foreign trade)

Types of Bill

Documentary Bill
Clean Bill
Demand Bill

Advantages of Bill of Exchange

A Bill of Exchange is used in settlement of debts
It fixes the date of payment
It is a written and signed acknowledgment of debt
A debtor enjoys a full period of credit
A drawer can convert the bill into cash by getting it discounted with the bank

3. Cheque

A cheque is an unconditional order, drawn on a specified banker and is payable on demand. A cheque is one of the earliest forms of a credit instrument.

Non-Funded Credit Instruments

1. Letter of Credit

In a financial letter of credit (LC), the creditor guarantees the payment of the counterparty’s obligation and, in return, receives a one-time or periodic fee.

2. Bank Guarantee

A bank guarantee is defined as “A contract to perform the promise or discharge the liability of a third person in case of his default.”

Credit Derivatives for Risk Mitigation

1. Credit Default Swaps (CDS)

This is the most popular credit derivative. In a credit-default swap (CDS), the buyer pays a one-time or periodic fee to the seller of protection for the right, in the case of default by a particular borrower, to receive cash compensation or to sell a credit instrument issued by the borrower at a specified price (near par).

3. Total Return Swaps (TRS)

In a total-return swap (TRS), the protection buyer exchanges the total returns on a specified underlying debt instrument for a set of stable cash flows.

4. Collateralized Debt Obligations (CDOs)

CDO is a way of creating securities with widely different risk characteristics from a portfolio of debt instruments.

Other Instruments

1. Credit Card

The credit card is an example of a common credit instrument. Using a credit card to pay for a purchase creates a contract between the buyer and the seller.

2. Banker’s Acceptance (BA)

A banker’s acceptance (BA) is another type of payment guarantee. A short-term credit investment created by a non-financial firm and guaranteed by a bank.

(Banker’s acceptances are very similar to T-bills and are often used in money market funds.)

Capital Structure – Sourcing of Funds

Common Equity
1. Funds belong to the owners
2. No legal obligation to pay dividends
3. Contributed when formed
4. Generates and retains profit (ROE)
Debt
1. Obligation to make a payment to another entity at some point in time.

A. Stock Certificates – Evidences of Ownership in a Corporation

Preferred Stocks
Common Stocks

B. Bond Certificates – Are Evidences of Indebtedness of a Corporation to Bondholders

Debenture Bonds
Collateral Trust Bonds
Mortgage Bonds
Sinking Fund Bonds
Registered Bonds
Guaranteed Bonds
Convertible Bonds
Redeemable Bonds
Serial Bonds
Income Bonds
Coupon Bonds
Profit-Sharing Bonds

C. Money Market Bills – Are Negotiable Financial Instruments Bought and Sold in the Market

A money market is a meeting place for users and suppliers of short-term funds. Parties to a money market transaction: Fund User, Fund Supplier, Broker.

Kinds of Money Market Instruments

Interbank Call Loans
Promissory Notes
Repurchase Agreement
Certificates of Assignments
Certificates of Participation
Commercial Papers
Central Bank Certificate of Indebtedness (C.B.C.I)
Treasury Bills
D.B.P Progress Bonds
Other Government Securities

B. Credit Instruments for Commercial Purposes

Promise-to-Pay Instrument
- Promissory notes (negotiable, non-negotiable, secured, unsecured)
Financial Institution Deposits
- Letter of credit (commercial, traveler)
- Open book accounts
Order-to-Pay Instrument
- Checks
- Crossed Check
- Post-Dated Check
- Stale Check
- Manager’s Check
- Cashier’s Check
- Treasurer’s Check
- Bouncing/Rubber Check
- Counter Check
- Certified Check
- Falsified/Forged Check
- Personal Check
- Business Check
- Cancelled Check
- Returned Check